Every investor wants to include the best stocks in their portfolio. However, with a seemingly endless line of options, how do you choose? If you could rank your target stocks based on a standard checklist to check their quality, the process of selecting stocks would be quite simple. In that case, have you heard of the Piotroski score? Check out this blog to know the meaning of the Piotroski score and how it can help you shape your portfolio.
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What is meant by Piotroski score?
A Piotroski Score is a financial metric developed by Joseph Piotroski, an accounting professor at the University of Chicago. It is a tool used to assess and score a company’s financial health and fundamental strength based on a series of parameters. Investors and analysts then use this score to help identify promising investment opportunities. The Piotroski score ranges from 0 to 9 and a higher score indicates better financial health for the company.
The Piotroski Score is based on nine financial criteria, each of which receives a score of 1 if it meets a specific condition and 0 if it doesn’t. These criteria include factors like profitability, leverage, operating efficiency, and the quality of earnings. The final Piotroski score is derived by summing up these points and thereby understanding valuable insights into the financial health of a company. A high Piotroski Score suggests that a company may have sound financial fundamentals and is effectively managing its resources. On the other hand, a low score may indicate financial red flags that warrant further investigation.
How to calculate a Piotroski score?
Calculating Piotroski Score involves assessing a company’s financial statements and assigning points based on specific criteria. These criteria are broadly categorised under three heads namely,
- Profitability
| Category | What does it signify? | Score |
| Net Income | The ability of the company to make a profit. | Positive score (1) if the company has made net income in the current years, if not, negative score (0) |
| Operating Cash Flow vs. Net Income | The quality of earnings if the company can generate net income higher than its cash flow from operations. | Positive score (1) if the net income is higher, negative score (0) in other case. |
| Return on Assets | Efficiency of the company to manage assets in order to make profits. | Positive Score (1) if the ROA is higher than the previous year, negative score (0) in other cases. |
| Operating Cash Flow | Analysis of the company’s ability to generate cash flow after adjusting for depreciation and changes in accounts receivable and inventory. | A positive score (1) of operative cash flow is positive, negative score (0) is in other cases. |
- Leverage, Liquidity and Source of Funding
| Category | What does it signify? | Score |
| Leverage | Level of debt in the company | A positive score (1) if the debt levels decreased as compared to the previous year and in other cases, a negative score (0) |
| Current Ratio | The ability of the company to pay off its short-term liabilities | A positive score (1) if the current ratio has increased as compared to the previous year and in other cases, a negative score (0) |
| Change in the Number of Shares Outstanding | The ability of the company to grow without diluting too much equity. | A positive score (1) if the company has not issued any fresh equity in the previous year and in other cases, a negative score (0) |
- Operational Efficiency
| Category | What does it signify? | Score |
| Gross Margin | The ability of the company to increase its gross margin | Positive score (1) if the current year gross margin is higher than the previous year, if not, negative score (0) |
| Asset Turnover Ratio | The ability of the company to use its assets effectively | Positive score (1) if the current year asset turnover ratio is higher than the previous year, if not, negative score (0) |
Calculate: Capital gains on your investments
How to use Piotroski score in stock picking?
The steps for stock picking using the Piotroski score are mentioned below.
- The investor should begin by collecting financial data from the selected companies.
- The Piotroski Score can then be calculated using specific criteria, with one point assigned for each criterion met and zero points for unmet criteria.
- Companies with higher Piotroski Scores should be given priority by the investor.
- Companies with low Piotroski Scores should be subject to thorough investigation to understand the reasons behind their scores.
- To make informed decisions, the investor should compare Piotroski Scores among companies within the same industry.
- It is advisable for the investor to integrate the Piotroski Score with other analyses to get a comprehensive view.
- Maintaining a long-term investment perspective is essential when considering the Piotroski Score, as it reflects a company’s fundamental health over time.
- Investors should regularly monitor and update the Piotroski Scores of the companies in their portfolio, as financial health can change over time.
Is Piotroski score reliable?
The Piotroski Score can be a useful tool for assessing the financial health of companies, but its effectiveness in predicting stock performance may vary depending on various factors. Investors often use it as one of several indicators in their decision-making process, but it should not be the sole basis for investment decisions.
What are the limitations of using the Piotroski score?
The limitations of using the Piotroski Score include its reliance solely on historical financial data, which may not capture future market dynamics, and its inability to consider qualitative factors such as industry trends or changes in management, potentially leading to missed investment opportunities or false positives.
Conclusion
Piotroski score is a widely popular mode of stock selection across the globe, especially for investors focusing on the core fundamentals of the company in building a long-term investment portfolio. This technique is quite easy to understand and implement and therefore allows wider access for investors even if they are beginners in stock markets.
